The main reasons to consider investing in Chinese debt are its diversification benefits, yield differential versus major developed market bond markets, and the potential for currency appreciation in the long run.
Chinese bonds are firmly on the map, having been included in the FTSE World Government Bond Index from last month. They certainly represent a large and liquid pool of securities but have other substantial benefits for investors. They are still broadly classified as developing market debt, which means a low synchronization of policy cycles: the People’s Bank of China (PBoC) has been easing policy while central banks such as the Fed and Bank of England are gearing up to tighten monetary policy. This results in a low correlation with most developed markets, meaning Chinese bonds can provide relatively attractive diversification benefits for global bond investors (see figure below).
Low Correlation with Major DM Bond Markets (in USD Unhedged Terms)
Chinese bonds also provide attractive yield enhancement relative to major developed market (DM) government bond assets.
Looking ahead, we expect Chinese bonds to generate higher returns than major DM government bonds over the medium to long term. This view is based on China’s existing yield advantage versus major DM government bonds as well as our constructive view on the outlook for the CNY. On a real yield basis, Chinese bonds offer a positive inflation-adjusted yield – a rare commodity in today’s world.
In the long term, we hold a constructive view on the CNY due to China’s resilient growth relative to major DM/EM markets. This view is bolstered by the continued opening up of Chinese financial markets (e.g. global bond index inclusion) and an increase in its international currency functions (e.g. the Chinese currency’s market share as an international reserve currency has risen since its inclusion in the International Monetary Fund’s SDR basket of five currencies). In our view, the onshore Chinese bond market provides a relatively conservative way of accessing these longer-term currency tailwinds.
However, attempting to actively position for short-term currency movements of any currency can be very difficult. As a developing market, China is still subject to fluctuating investor sentiment and short-term volatility. Active investors may choose to hedge if they have concerns about near-term risks such as China’s slower growth, the PBoC’s easing stance, tensions with the United States and the risks in the country’s credit sector. Although, it is important for potential hedgers to be mindful of the high hedging costs (e.g. USD-based investors have to pay the nearly 3% short-term CNY interest rate as part of the hedge).
Differences Across China Government Bond Exposures
Chinese government bonds have enjoyed strong inflows as China has been included in more EM and global government bond indices. Standalone allocations to China bonds are also becoming increasingly common as investors seek to both enhance returns and reduce the volatility of their bond holdings via diversification.
For those investors seeking to meet these goals through ETFs, understanding how indices differentiate themselves is important in being able to better understand how to integrate Chinese exposure into bond portfolios.
In a recent article, we compare four popular Chinese bond indices, looking at the key inclusion criteria, index characteristics and risk-return profiles.
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